Before you proceed with any new business project, you have to think about what's in the budget. Calculating the cost of capital is one method a business owner can use to answer those fundamental questions.
This is because understanding the cost of capital helps business owners know the minimum return they need to justify investing in new projects.
It can also be an important calculation for businesses raising investment since investors can use it to gauge potential returns.
Here’s a closer look at the formula businesses can use to calculate the cost of capital and the valuable insights it can provide.
What is the cost of capital?
The cost of capital refers to how much it costs a business to fund its operations. It considers both the cost of equity, which is the return a business expects to make for its equity investors, as well as the cost of debt, or the interest payable on company debts, such as loans or bonds.
A company’s cost of capital will depend largely on the mix of financing it uses to fund its business.
Why is cost of capital important?
There are often many options available to business owners as they seek to grow and expand their companies. For example, purchasing new premises, investing in better equipment or expanding into a new market. Establishing the cost of capital provides insight as to whether or not each proposed project will generate sufficient returns to exceed the total cost of the funds used to pay for it.
“To get support from investors and lenders, you need to explain how your ideas will make the business more valuable,” says Anthony Impey MBE, CEO at Be the Business, a not-for-profit organisation supporting business owners. “By understanding the cost of capital, you can better explain how your ideas will generate enough profit to make it worth the investment.”
How to calculate the cost of capital
The first step towards understanding your cost of capital is to evaluate the cost of any debt your business has, as well as the costs of equity, such as dividends paid to shareholders.
Cost of capital formulas
Cost of debt formula
The cost of debt formula calculates how much interest you need to pay on any debt investments your company has. For example, bonds and loans. It also usually considers tax.
Cost of debt = interest expense / total debt x (1-T)
Interest expense
This is the interest rate you pay on any debt used to fund the project.
Total debt
This is the total amount of debt used to fund the project.
(1-T)
T is your company’s tax rate.
Cost of debt formula example
Imagine a company has a £500,000 loan with a 5% interest rate and a £100,000 loan with an interest rate of 6%. The company pays tax at 19%. To calculate cost of debt, you first need to work out the monetary value of your interest payments as follows:
- £500,000 x 5% = £25,000
- £100,000 x 6% = £6,000
Then you add the total interest and divide this by the total amount of debt:
- £25,000 + £6,000 = £31,000
- £31,000 / £600,000 = 0.05
Finally, since interest expenses on debt are tax deductible and therefore can reduce the cost of debt owed, you can then perform the following calculation to account for tax:
Cost of debt: 0.05 x (1-0.19) = 0.04
This means the company's cost of debt after tax is 4%.
Cost of equity formula
The cost of equity refers to the return your company expects to make to its equity investors, such as shareholders:
Cost of equity = Rf + b(Rm-Rf)
Risk-free rate of return (Rf)
“The risk-free rate of return indicates the returns available on a zero-risk investment,” says John Edwards, CEO of the Institute of Financial Accountants. Government bond yields in the relevant currency are most commonly used for the risk-free rate of return, as they are the lowest-risk investment vehicle, he adds. This could be, for example, the 10-year UK government bond yield, which is about 3.5%.
Beta (b)
Beta is a measure of how risky an investment is, compared to the market as a whole. “An investment with a Beta greater than 1 is riskier than the market as a whole, so should offer a commensurately higher reward,” Edwards says. For private companies, the easiest way to find this number is to use the average beta of publicly-traded companies that are similar to yours.
Market rate of return (Rm)
This is the amount by which, over a long period of time such as 5 or 10 years, a stock market generates higher returns for investors than near-risk-free Government bonds. In other words, it is the difference between returns on equity stock and the risk-free rate of return from government bonds.
The idea is that investing in riskier securities must be accompanied by greater potential rewards. For example, if government bonds generate 3.5% returns, an investor would likely opt for the stock of a company that gave more than 3.5% returns, such as 8%. Here 8% - 3.5% (shown as ‘Rm-Rf’ in the above formula) equals 4.5%, which is also called the ‘equity risk premium’.
“The market rate of return indicates the acceptable minimum level of return investors will need to see in order to invest,” Edwards shares. The equity risk premium represents the additional return investors need to see above the risk-free rate of return to make an investment attractive, he adds.
Cost of equity formula example
For this example, let’s use the 10-year UK government bond yield of 3.5% for Rf.
For Rm, we can use the average 5-year return for the FTSE 100 of about 7.07%.
The Beta for our company is 1.2. To calculate the cost of equity:
Cost of equity: 3.5 + 1.2 x (7.07-3.5) = 16.78%
This means the cost of equity financing is 16.78%.
Weighted average cost of capital (WACC) formula
While the basic cost of capital calculations consider the cost of debt and cost of equity, the WACC formula goes further by adding a weighting in proportion to the amount in which each is held.
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How to use cost of capital formulas
As well as being used to evaluate future business plans, cost of capital formulas can be used to determine the best source of funding for major new projects, such as whether it’s better to borrow money or to raise new investment into the business, explains Impey.
And it can also support you in evaluating the progress of ongoing projects by comparing their costs. “It’s something that should be analysed regularly,” Impey says. “Ideally, businesses should strive to balance financing while keeping the cost of capital low.”
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